It has been nearly seven years since the Great Recession, and after a painfully slow recovery, the Federal Reserve (Fed) finally decided in December that the U.S. economy no longer needs emergency measures of support. The Fed, which had supported asset prices with aggressive monetary stimulus, initiated its first Fed Funds rate hike since 2006, thereby beginning the process of removing the safety net to which investors had grown accustomed. Notably, this move is in direct contrast to other global central banks, including those in Europe, Japan and China, where policy makers continue to promote lower interest rates and aggressive monetary stimulus in order to spur economic growth.
We began writing more about this divergence in monetary policy in the fourth quarter of 2014, when the Federal Reserve finally ended its quantitative easing program. This divergence in policy has gathered steam, with other developed economies standing in stark contrast to the U.S. For example, the European Central Bank (ECB) announced increases to its quantitative easing measures in December in an effort to spur the economy and boost inflation. Thus, while the U.S. 2-year yield drifted above 1 percent for the first time since 2010, the German 2-year note yielded -0.35 percent, revealing the largest gap in over 15 years. In fact, negative yielding government debt in Eurozone mounted to over $3 trillion in the fourth quarter — we live in remarkable times.
The U.S. rate hike was well-telegraphed by the Fed, and the market largely weathered the news well. Yields rose across the curve in anticipation of the event and following the announcement, with the most notable increases occurring in the belly of the curve where 2- and 5-year Treasury bond yields rose over 40 basis points during the quarter. The 2-year Treasury yield ended at 1.05 percent, marking the first year it has ended over 1 percent since 2009. The 10-year Treasury ended the year at 2.27 percent, up just 10 basis points from the prior year-end, as the market expectations for inflation remain subdued.
U.S. fixed-income securities posted negative returns for the fourth quarter. The Barclays U.S. Aggregate Bond Index (“Barclays Aggregate”), the proxy for the broad investment-grade U.S. fixed income market, fell 0.57 percent for the quarter. While all sectors of the bond market fell for the quarter, Treasuries and TIPs led declines as yields shifted higher. Long-duration securities, which are more sensitive to movements in interest rates, led the declines. Across fixed income sectors, securitized assets held up the best, as investments in MBS showed resilience with strength in the housing and labor markets as tailwinds.
Non-U.S. fixed income underperformed domestic, particularly due to dollar strength weighing heavily on returns, as the Barclays Global Aggregate ex-U.S. Index posted a -1.14 percent return for the quarter. Emerging market bonds led returns for fixed income globally, with the JP Morgan EMBI+ Index gaining 1.77 percent for the quarter and up 1.82 percent for the year.
Higher quality bonds again performed much better than lower quality in the fourth quarter. Equities and High Yield bonds sold off sharply in the third quarter, and while equity markets rebounded sharply, selling pressure remained on High Yield securities. High Yield corporate bonds fell 2.07 percent in the fourth quarter, as measured by the Barclays US High Yield Corporate Bond Index, capping the first annual decline for High Yield bonds since 2008, with the index falling 4.47 percent for the year. Of particular note, this is the first annual decline for High Yield securities outside of a recession since at least the 1990s. In particular, falling oil prices caused acute price declines in the Energy sector, which comprises about 15 percent of the index, dragging down total returns and causing a contagion effect that negatively impacted the rest of the High Yield bond market as well.
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